Capturing investment potential of developing countries

Emerging market debt (EMD) is rapidly becoming a mainstream asset class. But what are the key characteristics of EMD bonds and what should investors bear in mind?

Yield and price

In common with other types of bond, the price of EMD is inversely related to yield, the rate of interest on the debt. Think yield up, price down. Yield down, price up.

For the bonds issued by the governments of emerging market countries, there is a strong, inverse relationship between the prices of the bonds issued by a given nation and the prevailing level of interest rates in the country.

As an example, Brazilian sovereign bonds performed well over the first couple of months of 2017 as the country´s central bank cut interest rates.

Interest rate changes

Often, just changing market expectations on interest rates are enough to push government bond prices in one direction or another.

For instance, if a country reports lower-than-expected inflation, investors tend to view this as positive for the bonds issued by the country´s government, typically pushing up prices of the bonds in the market.

This is because central banks generally react to lower inflation by keeping interest rates lower than would otherwise be the case.

Central banks react to lower inflation by keeping interest rates low.

Issuing debt

When EM countries issue debt to investors they want to pay the lowest possible rate of interest on the debt. Those purchasing the debt from the issuing country do so on the agreement that they will receive a regular interest payment, or coupon, which is typically fixed for the life of the bond.

As an example, in 2017 Mexico issued bonds paying annual coupons equal to 4.15% of the issue price, with the bond maturing in ten years.

Investors can hold the bond until maturity in 2027 and receive this same fixed coupon throughout the life of the bond, provided that Mexico continues to honour its debt repayments.

Mexican standoff

At maturity, the same investors will also receive their original investment (an amount known as the “principal”) in the bond back in full from the Mexican government.

However, an investor could alternatively elect to sell the bonds in the market well before maturity, passing on their right to receive the coupons and the bond´s principal at maturity to other investors.

As the price of the bond fluctuates in the market, it could be possible to sell the bonds for a profit within a relatively short time scale.

For example, the value of the bonds could increase if interest rates in Mexico fall or if investor demand for Mexican bonds rises.

Positive scenario

Over the long term, a positive scenario for an investor in an EM bond would be that the economy and underlying fundamentals of the given country steadily improve, such that the country becomes more and more akin to a developed market.

For instance, robust, positive economic growth, above the average of developed countries, accompanied by relatively low inflation, could enable the given EM authorities to keep interest rates down.

In combination with this, a positive external trade balance, with growing exports, can also help EM countries to build up foreign currency reserves over time.

Such outcomes can effectively lead to EM countries eventually catching-up with their developed counterparts.

The valuations of both EMD and the local currencies of EM countries are likely to rise against this backdrop.

Stagflation risks

In contrast, a highly difficult environment for EM bonds would be “stagflation”, a situation where economic growth declines at the same time as inflation rises.

In this case, interest rates could need to increase significantly to combat inflation while the deteriorating economic situation could also see the country downgraded by credit ratings agencies and viewed as more likely to default on its debt repayments.

In such an adverse scenario, both the valuations of EMD and the local currencies of EM countries are liable to fall.

Risk versus return

For higher risk, investors naturally expect higher potential returns. The various segments of global bond markets vary in their risk/return profiles, with the bonds issued by the major developed countries viewed as the least risky, and hence with theoretically low potential returns.

Meanwhile, some of the bonds issued by large, global corporations are viewed as low risk, carrying an “investment grade” rating from the ratings agencies, a designation of high quality.

They are, however, also seen as being riskier than the major developed, government bond markets.

To put this in context, there is virtually no risk that the US will ever fail to repay the interest it owes on the debt that it has issued.

However, there is always some risk that the business prospects of some of even the most well-respected, established multinationals could take a turn for the worse.

It follows that bonds issued by companies with the lower ratings, known as high yield, or junk bonds, are viewed as being much riskier again.

Inbetween risk

So where does EMD rank in all this? In general, EMD lies somewhere between investment-grade and high-yield bonds on the risk spectrum.

At the same time, the risk profile between EM countries can vary greatly, and can also change significantly over time. The good news is that in practice relatively few EM countries default on their debt obligations.

Evolving risk

Following some improvement in its economy over many years, the risk of investing in Brazilian debt was seen to have decreased so much that ratings agencies awarded the country a coveted investment grade status in 2008.

Fast forward some years later, however, and Brazil has lost its investment grade status with the slump in global commodity prices having pushed the country into deep recession.

Alongside the economic problems, political upheaval was also perceived as having made Brazilian sovereign bonds riskier when the country was downgraded in 2015.

Meanwhile, some EMD, such as that issued by Ghana, is referred to as being “frontier” debt. As well as being perceived to be at the higher end of the risk spectrum, frontier sovereign issuers tend to be relatively new to the market.

US dollar versus local EMD

Investors can choose to invest in either US dollar denominated EMD or local currency EMD, with this latter denominated in the currency of whichever country is issuing it.

In general, US dollar denominated debt is more stable as the potential returns from local currency EMD for global investors very much depend on the performance of the country´s currency as well as its bonds.

However, in the case of an EM country that is undergoing long-term improvement and closing the gap with its developed peers, local EMD has the potential to provide greater returns versus US dollar denominated EMD.

This is because investors in local EMD can reap the benefits of strengthening EM currencies as well as any price appreciation in the underlying bonds themselves.

When the fundamentals of EM countries go through a phase of strong improvement, EM currencies can often provide attractive returns well in excess of any price appreciation from the underlying EM bonds themselves.

US dollar denominated debt is more stable as potential returns from local currency EMD is dependent on the performance of the country's currency and bonds.

EMD buckets

As with the other segments of the global bond markets, there are different sub-groups of bonds within the EMD category in which investors can choose to invest.

For instance, investors in EMD are not just constrained to purchasing the bonds issued by EM governments. It is also possible to invest in EM corporate bonds, a sub-group that has grown rapidly in popularity over recent years.

Within this sub-group, there are also a variety of different risk/return profiles to consider as some EM corporate bonds have investment grade status while others are ranked as high-yield bonds.

Investing in EMD

For the majority of investors, the most practical way to obtain exposure to EMD is through investing in mutual funds. Some funds target just US dollar denominated EMD while others will focus solely on investing in local currency EMD.

In both situations, active fund managers who select issues on a case by case basis, taking into account their own view of valuations, will typically invest in a wide variety of EMD.

This can include issues from a range of countries and global regions, enabling investment managers to incorporate a diverse range of EMD corporate bonds and sovereign bonds within their funds.

It is also possible to gain exposure to EMD by investing in ETFs, funds that attempt to replicate EMD index returns as closely as possible by merely tracking the market and having the same weightings in each bond issue as the index itself.

Strategic investment

As there is some volatility involved with investing in EMD, a longer-term investment strategy can help smooth out some of the inevitable peaks and troughs in valuations over time.

Investing in a broad, diverse range of EMD issues, across a wide geographical spectrum, can also enhance risk management as opposed to investing in just a few chosen names in isolation.

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